This strategy uses corporately-owned, cash-value life insurance to transform taxable assets into a tax-exempt asset class that earns an attractive internal rate of return which isn’t subject to the potential for loss. If you’re an owner of a mature Canadian Controlled Private Corporation (CCPC) holding estate-bound assets or with surplus cash flow, this concept may be of interest.
Three key features make the Corporate Estate Bond strategy an attractive one:
1. Passive assets are turned into tax-exempt onesIncome from passive corporate assets is taxed at a high rate. Most provinces have corporate tax rates of 50% - 54% (in Alberta, it’s 46.67%). The Corporate Estate Bond strategy turns passive assets, which generate taxable income within the corporation, into tax-exempt corporate assets.
2. It can help you retain the small business deductionPassive corporate investment income exceeding $50,000/year causes a grind on the small business deduction. The small business deduction reduces corporate tax rates for CCPCs and is applicable to active business income up to the corporation’s annual business limit. The federal business limit is $500,000.
The small business deduction is lost at the rate of $5 for every $1 of passive investment income earned in excess of $50,000 during the previous fiscal year. At $150,000 of passive investment income, the small business deduction is completely lost. If the small business deduction is lost, active business income is taxed at a higher rate, for instance, it would be 23% instead of 11% in Alberta.
The Corporate Estate Bond strategy can reduce or eliminate the loss of the small business deduction because it effectively results in passive assets producing tax-exempt income, where the growth is not subject to the $50,000 passive income test.
3. Heirs can receive a tax-free capital dividend
Typically, heirs don’t receive cash even after the estate has paid the capital gains tax on the deemed disposition of shares. They get cash by paying themselves a taxable dividend. By comparison, the Corporate Estate Bond strategy creates a mechanism whereby heirs can receive a tax-free capital dividend on the death of the insured shareholder.
If set up properly, the owner and beneficiary of the policy will be the corporation. On the death of the insured owner, the death benefit proceeds will pay into the Holdco. The Capital Dividend Account (CDA) will be credited with the death benefit proceeds less the adjusted cost basis (ACB) of the policy. The estate or the heirs of the shares can then declare a tax-free capital dividend out of the CDA. Thus, the heirs receive tax-free money. The portion of the death benefit represented by the ACB may be paid out, but as a taxable dividend. Fortunately, the ACB is only a small fraction of the death benefit.
How does the Corporate Estate Bond strategy work?
This strategy involves using surplus corporate assets/cash flow to fund a permanent life insurance policy that has cash value. Premiums are paid into the policy from the corporate asset base or from corporate cash flow. Cash value growth in the policy is tax-exempt. By paying the premiums, passive assets generating taxable income are transformed into a tax-exempt asset class.
Participating Whole Life insurance is often the policy type of choice for this strategy. It has guaranteed cash value growth and attracts policy dividends which may be used in a variety of ways. The most common way is to purchase additional permanent insurance, called paid-up additions. Once posted to the policy, this dividend-dependent non-guaranteed cash value growth vests immediately. Policy values for both cash value and death benefit can only go up, never down – unless the policy owner elects to remove some of the cash themselves.
In the early years, the Equivalent Internal Rate of Return (IRR) required in a traditional investment vehicle to net the same cash value result as is provided by the whole life policy is very low. In fact, it’s hugely negative. Conversely, the equivalent IRR on the death benefit is incredibly high. In the long run, the equivalent IRR for both cash value and death benefit settles at about 7%. Keep in mind that this is in a tax-exempt vehicle that cannot go down in value. As shown above, this means the policy value growth is not slowed by high corporate passive income tax rates, nor is the growth counted toward the $50,000 passive corporate income limit allowed before the small business deduction begins to grind away.
This strategy offers many benefits to shareholders and their heirs, which makes it an attractive option for business owners seeking greater tax efficiency in their estate plan. To demonstrate, here’s an example:
Matthew (a 52-year-old male non-smoker) and Courtney (a 50-year-old female non-smoker) have $3.4 million of surplus estate-bound conservative investments in their Holding Company. They also have considerable personal wealth. They know they’ll never need to use all of this money and want to pass it onto their adult children in a tax-efficient way.
Their Wealth Preservation Advisor at CWB Wealth Management proposes they consider reallocating $100,000 per year for 20 years from their passive corporate assets toward funding a whole life insurance contract. This represents a draw rate of less than 3% and will allow them to purchase a policy with an original face amount of $3.66 million.
The policy has guaranteed annual cash value growth and non-guaranteed policy dividend growth that vests immediately, so it cannot go down in value – only up! The policy dividends provide a growing death benefit and cash value.
Using Courtney’s age, let’s compare 20 annual deposits of $100,000 into a life insurance contract with 20 annual deposits of the same amount into a traditional balanced investment portfolio. In the chart below, values for the Corporate Estate Bond strategy are based on the current performance bonus rate of 5.5%, so we’ll use this rate for the traditional investment alternative as well to make a clean comparison. The column labelled “Corp Estate Bond Net Estate” represents the Death Benefit less the ACB paid out as a tax-free capital dividend via the CDA, plus the after-tax value of the ACB paid out as a taxable dividend.
As you can see, at each age the net estate value created by the Corporate Estate Bond insurance strategy significantly surpasses the net estate value created by traditional investments.
So, this is clearly the winner for Matthew and Courtney, should they qualify to implement it with their good health.
To see if a Corporate Estate Bond or other planning strategies could help move you closer to your business and estate planning goals, please reach out to one of our CWB Senior Planners or a CWB Wealth Preservation Advisor for a conversation about your particular needs.
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